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Michael Luddy

Once a world superpower, Russia has rebounded from its fall to become one of the fastest growing emerging markets in the world. Russia's wartime infrastructure is still used today to make it the largest producer of armaments in the world.^[1] Russia's technical and scientific expertise did not completely leave in the "brain drain" as it is the second largest space launch provider in the world and the third largest destination for outsourcing software and programming. Russia's government will even be making a $7B investment into nanotechnology.^[2] However, the majority of Russia's wealth comes from its natural resources. Russia is the largest natural gas producer^[3] and the second largest oil producer in the world.^[4] About 80% of the country's exports come from oil, natural gas, metal, and timber. Oil alone accounted for 30% of GDP and 65% of exports in 2007.^[5]

Russia has the 11th largest GDP in the world, and since 2000, Russia's middle class has grown 700% and 14% of the population is in poverty, down from 30%.^[6] At the same time, the gap between the rich and poor is growing. Inflation has doubled since the beginning of 2007 and corruption is commonplace throughout much of the country. In 2008, Forbes rated the most corrupt countries in the world and on a scale of 1-10, Russia received a score of 2.3 meaning it had "rampant corruption".^[7] Russia relies heavily on its natural resources, but it's greatest source of wealth, oil, finally seems to be slowing its production. However, high taxes are deterring oil companies from trying to discover new oil fields. Despite the slowdown in oil, Russia is also one of the world's top producers of timber, iron ore , gold, diamonds, and nickel.^[8] The growing middle class in addition to real income doubling since 2000 has driven a boom in real estate and car sales, as well as pushing up earnings for Russia's retail companies. Russia's expanding economy will only grow as much as its infrastructure allows it and, according Merrill Lynch, Russia could spend upwards of $195B on infrastructure between 2008 and 2011.^[9]

Major Russian Companies

Energy

• LUKOIL (LUKOY) is one of the largest integrated oil and gas companies in Russia.

• Gazprom(GZPFY) is Russia's largest natural gas producer.

• Rosneft is an integrated oil company.

• TNK-BP (RTC:TNBP) is an integrated oil company.

Technology

• IBS Group Holding Ltd. is the largest software company in Russia.

• Yandex is the leading Russian search engine.^[10]

Banking

• Sberbank Rossii OAO is Russia's largest bank.

Telecommunications

• Open Joint Stock Company Vimpel-Communications (VIP) is the largest telecom operator.

• Mobile TeleSystems (MBT) is the largest cell phone communications provider.

• Rostelecom (ROS) is a telecom services provider and long distance carrier.

Industrial

• JSC MMC Norilsk Nickel (NILSY) produces nickel, copper and palladium.

• Metalloinvest makes up about 40% of Russia's iron ore production.

• Rusal is the largest producer of aluminum in the world.

• Severstal' OAO is the largest steel producer in the country.

• Ilim Pulp Enterprise is a leading timber company.

Retail

• X5 Retail Group NV (FIVE-LN) is Russia's largest retailer.

• Magnit (MGNT-LN) is a Russian food retailer.

Transportation

• Aeroflot OAO (AFLT) is a major Russian airline.

• Russian Railways is a government owned railroad company that which is the 4th largest Russian company by revenue.

Foreign Companies Invested in Russia

• BP owns a 50% share in TNK-BP, a Russian energy company. TNK-BP accounts for 30% of BP's oil production and about 10% of BP's profits.

• CONOCOPHILLIPS (COP) has a 20% share of LUKOIL (LUKOY).

• Renault acquired a 25% stake in Autovaz, a Russian car manufacturer.

Exchange Traded Funds

• Market Vector Russia ETF Trust (RSX)

Trends and Forces

Russia’s Oil Growth Could be Slowing

Russia is the world’s 2nd largest oil producer^[11] with production peaking at 9.9 million barrels per day in October 2007.^[12]> Oil makes up 65% of the country’s exports even with the government’s 65% duty on oil exports (applied when price per barrel is over $25). Since 2001, Citibank estimated that Russia made up about 80% of the growth in oil production not coming from OPEC. ^[13] Over 30% of Russia’s GDP is from oil which is twice the amount it was in 1999. ^[14] However, oil production may be beginning to temper. Oil production has been declining since Oct 2007 and the heavy taxes put on oil companies by Russia’s government have deterred many new exploration projects. Just over 90% of exported oil profits are seized by the government in some form. ^[15] The main surge in Russia’s oil growth came when companies were developing older fields, many of which were abandoned after the fall of the Soviet Union, because there was a tax break on older fields. Many of those fields have dried up now, and the heavy tax burden has forced a lot of companies to simply hoard their profits as they wait for a change in the tax laws. BP owns 50% of TNK-BP, a Russian oil company, and while TNK-BP makes up 30% of BP’s production, it only generates 10% of BP’s profits. ^[16]

Corruption Stifles Economy and Foreign Investment

In a 2008 study by Transparency International, Russia was ranked 143 out of 179 in a list measuring corruption in countries. ^[17] This ranking meant Russia is “rampant” with corruption, but the new President, Dmitry Medvedev, has announced plans to try to curb the country’s corruption. Medvedev is organizing a governmental task force and will be overhauling the court system. According to Vasily Piskayrov, a senior official at the Investigative Committee of the Prosecutor General’s office, corruption claims about a third of the government’s budget – about $120B. ^[18] This level of corruption deters investors from putting money into the country and in beginning of 2008, direct foreign investment fell 42.8%. ^[19]

Domestic Automakers Struggle to Compete with Foreign Brands

Russia sold 36% and 57% more cars by volume and by value, respectively, in 2007^[20] and sells more cars than any European country.^[21] However, over the past several years, Russia’s domestic car manufacturers have had essentially flat sales. Ford, on the other hand, now sells more cars in Russia in a week than they did in a year about a decade ago. ^[22] Half of all new cars in Russia were used imports in 2002 and, in an effort to stimulate domestic automakers, the government put a 25% duty on imported used cars. Russia’s major car makers like Autovaz and Guz Group had little benefit from the tax as their sales have remained stagnant. Russia’s car market has a lot of room to grow with only 200 of every 1000 people owning a car (in the US its 800 for every 1000), and on top of that, the nation’s real income has increased 100% since 2000 meaning more people can afford cars. ^[23] Growth has thrived despite rising oil prices and the Russian government tried attracting foreign makers to start building factories in the country. The combination of these two factors has given rise to a large presence of foreign automakers in Russia. Ford, Renault, GM, and Volkswagen all have factories in Russia.^[24]

Infrastructure Needs an Overhaul

Russia’s future growth depends largely on building an up to date and extensive infrastructure. Much of Russia is still using old infrastructure left from the fall of the soviet union due to Russia’s lack of investment since that time. Since the early 90’s, the number of airports being used dropped about 75% and underdeveloped railroads makes it impossible to transport goods from Europe to Asia according to Carina Baranova of Kazimir Partners.^[25] In June 2007, Merrill Lynch estimated that Russia will invest $195B in infrastructure over the next three years.^[26] Companies involved in infrastructure stand to benefit from Russia’s lack of development. Russian Railways plans to invest $16.6B in 2008 on new railroad networks.^[27] Russia’s major steel companies, Severstal and Evraz, will likely provide much of the steel for Russia’s expanding infrastructure. Between January and April 2007 construction and manufacturing revenues grew 157.8% and 120.5%, respectively.^[28]

Software Exports are Growing Rapidly

Russia is the 3rd largest destination for outsourcing software in the world, trailing only China and India.^[29] Russia's software exports have grown from only $120 million in 2000 to $1.5 billion as of 2006.^[30] Offshore programming is Russia's fastest growing sector while network integration is its largest. Russia also specializes in high end IT services such as algorithm design and microelectronics. The Russian government has begun building "technoparks" for these IT and software companies. The technoparks are built with all the necessary infrastructure and the firms that operate there pay lower taxes than they would at other locations.^[31]

Russia's Growing Wealth is Driving Retail and Real Estate

Russia’s economy has transformed since 2000: the middle class has grown 700%, the amount of people in poverty has decreased from 30% to 14%, consumer credit is up 45 times, real income has doubled, and the average salary has increased 800%.^[32] The amount of people with a net worth of $1m rose 15.5% and Moscow has more billionaires than London.^[33] The rising wealth in Russia drove retail sales up 13% in 2006. This rise in retail sales made X5 Retail Group NV the first Russian retail company to become one of the 250 largest retail companies in the world - it was #191.^[34] Real estate is going through a boom as well. About 50% of city dwelling Russian families have a second house outside the city and about 10% own a third property.^[35]

Rising Inflation

One of the major remaining problems in Russia is inflation. Inflation hit 15% in 2008 which is almost double what it was at the beginning of 2007. It is difficult for Russia to counter the inflation through interest rate hikes because consumer credit, while it has grown a lot, is still not large enough to make interest rate changes effective. In addition, Russia’s government has misaligned incentives as it is thriving off high oil – about a third of the government’s budget revenue came from oil in 2007.^[36] Lower inflation or an appreciation of the Ruble would result in decreased revenues for oil exports and therefore lower revenues for the government.

References

1. ↑ Wikipedia:Economy of Russia
2. ↑ Wikipedia:Economy of Russia
3. ↑ EnergyandCapital.com: The Russia ETF Poised to Ride the Country’s Status as Leading Natural Gas Exporter
4. ↑ The Economist - May 8, 2008: Trouble in the Pipeline
5. ↑ The Economist - May 8, 2008: Trouble in the Pipeline
6. ↑ Wikipedia:Economy of Russia
7. ↑ Forbes.com: The World's Most Corrupt Countries
8. ↑ Howstuffworks.com: Geography of Russia
9. ↑ Russiablog.org - July 7, 2007: Investing in Russia's Growth Sectors: Construction, Manufacturing, Retail Distribution
10. ↑ Yandex.com: As Russia Advances, High Tech Gets Left Behind
11. ↑ Wikipedia:Economy of Russia
12. ↑ The Economist - May 8, 2008: Trouble in the Pipeline
13. ↑ The Economist - May 8, 2008: Trouble in the Pipeline
14. ↑ The Economist - May 8, 2008: Trouble in the Pipeline
15. ↑ The Economist - May 8, 2008: Trouble in the Pipeline
16. ↑ The Economist: Crude Tactics
17. ↑ Forbes.com - June 6, 2008: Russia’s $120 Billion Elephant: Corruption
18. ↑ Forbes.com - June 6, 2008: Russia’s $120 Billion Elephant: Corruption
19. ↑ Forbes.com - June 6, 2008: Russia’s $120 Billion Elephant: Corruption
20. ↑ The Economist: Crisis? What Oil Crisis?
21. ↑ Businessweek.com - July 2008: Russian Auto Market Now Europe's Largest
22. ↑ The Economist: Crisis? What Oil Crisis?
23. ↑ Wikipedia:Economy of Russia
24. ↑ Businessweek.com - July 2008: Russian Auto Market Now Europe's Largest
25. ↑ Investing in Russia: The Case Grows Stronger
26. ↑ Russiablog.org - July 2007: Investing in Russia's Growth Sectors: Construction, Manufacturing, Retail Distribution
27. ↑ Investing in Russia: The Case Grows Stronger
28. ↑ Russiablog.org - July 2007: Investing in Russia's Growth Sectors: Construction, Manufacturing, Retail Distribution
29. ↑ Wikipedia:Economy of Russia
30. ↑ Wikipedia:Economy of Russia
31. ↑ Wikipedia:Economy of Russia
32. ↑ Wikipedia:Economy of Russia
33. ↑ BBC.co.uk: Russia's Economic Might:Spooky or Soothing?
34. ↑ Retailnu.wordpress.com: Chinese and Russian Retailers in the World's Largest Retailers List
35. ↑ The Escape Artist, Investing in Russia
36. ↑ Bonoboathome.blogspot.com: Russia’s Growing Inflation Headache